Options are financial products giving you the ability to trade on a market’s future value. When an option is purchased, a premium is bought for rights to trade any market at set prices. This is to happen before the expiration date reaches. Options are also the same as futures in this regard. However, unlike futures, options do not come with a trade obligation, so you don’t have to if you don’t want to trade.
For example, if gold sells at $1300 this entire week, and the price hits $1325, you can choose to exercise the options you have to purchase it at $1300. That is, $25 less than the current $1300 price.
If the gold price goes lower than $1275, you don’t have an obligation to purchase the gold at the market price of $1300. Although when you don’t trade, you’re risking losing the premium that was paid for that option.
If options are leveraged or not
Options are leveraged, just like CFDs. This is one of the primary reasons why any traders find them so attractive.
Considering the earlier example, purchasing gold options would have seen you part with less to open a position than I would have cost buying the gold itself. If the gold’s price had moved up, you could have sold your option even without having to exercise it. That way, you would have profited from the price movement of the gold without putting up too much capital. This makes options powerful trading tools.
The various uses of options
Most people trade options for three significant reasons: to hedge thus limit risks, to buy more time to make up their mind on whether a trade is suitable for them or not, and to make price movement speculations of various markets.
Even though options have other uses like in complex spread strategies, most traders use them for either of these three;
· Options hedging
Options were first devised to be hedging tools. For example, if you have stock of a given company and are worried that the stock’s price might fall in the not-so-far future. In such a situation, you can purchase an option to sell the stock you own. You will sell it at a price that is closer to the stock’s current market price. Should the price of stock fall, you have the choice of limiting losses by exercising the option. On the flip side, if there is an increase in your stock price, the only loss you will have incurred is the amount you paid to buy the option.
· Extending decision-making time
Options are also commonly used to buy you more time; that is, the time you need to decide if the trade you are about to engage in is worth it or not. Here, as opposed to purchasing a market you have doubts about, you will purchase the option of trading it before the set future date. If you decide you’d like to buy the market somewhere down the line, you will exercise the option.
· Options speculation
Options come with a flexibility that has helped them become popular speculation tools. The reason is the price at which an option trades varies depending on different factors. The factors include the amount of time left to exercise the option and the underlying market value.
Some common terms used in Options trade
At first glance, options might look complicated, more so because of the terminologies, traders use. Some of the major terms are as follows as well as their meaning:
- Holders and writers: Holders refer to the people buying options, whereas writers are the sellers of options. During a call, holders have the right to purchase an underlying market from writers. In a put, holders have rights to sell underlying markets to writers.
- Premium: This refers to the fees holders pay writers for options.
- Strike price refers to the price holders can call (buy) or put (sell) an underlying market.
- Date of expiry: This refers to the set date where an options contract will be terminated. Once this date has been reached, that option becomes worthless. Therefore, if that underlying market fails to it a strike price before the date of expiration, the holder won’ make a profit.
While options are flexible, they can be complex. Instead of purchasing a market hoping for a price increase, you need to consider ho much the price will increase by and determine when that movement will happen to profit from it.